Do You Cost Model? Why Not? PART III

Cost Modeling Purchasing Training

OK, so we’ve talked about the importance of cost modeling and why this is something you must be good at as a purchasing professional.

I’ve consistently seen that purchasing professionals want their finance people to do cost models and want their legal people to do contracts. These are career killing practices. Cut it out!

These are golden opportunities to make strengthen your arsenal, show that you defer to no one when driving aggressive TCO solutions, and that you understand every facet of what it is you are negotiating. Suppliers know when you don’t know. And they love it.

So we covered Must Cost Models last week and we will talk about Should Cost Models this week.

A should cost model is used when the product/service being purchased cannot be benchmarked via an RFX process (due to uniqueness of what is being purchased), and therefore the method of choice is to break down suppliers costs and find out what it “should cost” to be providing this product or service… hence the name.

This can be a great tool in negotiations. In an era where supply chain management is coming, putting things out to bid will happen less and less. Instead, you will be collaborating with suppliers in the supply chain with whom you have long term relationships to identify joint cost opportunities. Getting good at should cost models will greatly ease this transition.

The first guy who trained me in purchasing had no idea what he was doing. And he’d been at it for years. This was in a Fortune 50 purchasing department mind you. We had lots of accolades on the outside and lots of inept practices on the inside. Sound familiar?

I was negotiating a consulting agreement for unique services. That means that benchmarking was not an option (we’ll talk about benchmarking next week). Budget wasn’t overly constrained, so a must cost model wasn’t appropriate either. We needed to do a should cost model.

So Mr. Trainer had me do a cost model that looked at how many employees this consulting company had, what types of employees, how many computers they had, how many fax machines, what the square footage of their building was, and so on.

I then had to determine what each of those employees should be getting paid, what the cost of the hardware they had was, and what the cost of real estate was in that area. Then I added on insurance costs, burden rates, and many other extraneous pieces of financial information.

The net result? A multi-page spreadsheet that that couldn’t help me close a car door, much less a negotiation. It took two full weeks of my life – that I’ll never get back – to gather that data.

A should cost model was the right tool, but the right tool can be used wrong. What I should have done (or rather, what Mr. Smarty Pants should have told me to do) was something far more basic:

Let’s assume the consultant wanted $400/hour. I should have taken the consultant’s resume and shown it to the internal customer and ask “what would you pay this person if you were to hire them as a full time employee?” Let’s say the answer was $110K/year.

Now I just need a few more piece of information: burden rate, consultant utilization rates, and industry average profit margin. Burden rate (the costs of an employee beyond cash compensation – insurance, cubicle, 401K contributions, etc) is usually 30%.

Consultants usually have only about 50% of their time as billable. Anything less is a red flag. Anything more, and they aren’t spending enough time researching and ensuring they are at the top of their game.

Then if I were to look up the NAICS code for the consultant ( you can ask any supplier what their NAICS code is – it is 6 digits and you can then research financial averages for that industry), their profit margin would probably be about 50%. Consultants have high profit margins.

The average employee works 2,000 hours a year – a nice round figure. We will cut this in half though, due to billable time by consultants in the average year.

So let’s do the math:

$110K + 30% burden rate = $143K, which is the cost of hiring that consultant as an employee. It doesn’t matter that neither party is proposing to do this.

$143K + 50% industry average profit margin = $286K (I know you think it should be $214.5K – this is a common financial modeling mistake), which is what the consultant should then expect to gross in a year if both burden rate and industry average profit margins are included.

$286K/1,000 hours = $286/hour, which gives you a benchmark rate to work off of in should cost model based negotiations.

The argument is “if we were to hire you at market rate, and to add on burden to address all costs, and add on industry average profit margins for your NAICS code, and even assume only a 50% billable rate per year, we would still be at $286/hour vs the $400/hour you are asking for. Help me understand the data here, because my analysis points me in a different direction that what you’re charging.”

If you don’t think this works, you are dead wrong. The supplier will be stuck. You will have painted them in a corner. The data does all the talking. And compared to all the useless analysis I did before, this was a walk in the park.

I would like to run through many more examples, but it’s just not practical in a blog. The point is, you have to negotiate with data.

The first choice is benchmarking in most cases. If that is not available or feasible, then you move onto Must, Should, or Total Cost Modeling.

Suppliers hate it when you negotiate with data and they love it when you don’t.

Stop believing that just taking a negotiation class that teaches you how to influence with behavioral techniques is all you need. That only works in glossy airplane magazine advertisements.

You have to couple those techniques with in depth data analysis, and *only then* can you make a case for negotiation success.

Feel free to contact me if you want world class TCO training for your organization. Just don’t use any of the techniques I taught you above when we talk price!